Please, click here to read this article in pdf format: february-2-2011

Some quick comments for the mid-week, following up on our thesis that should the EFSF be used to purchase outstanding sovereign peripheral debt, the Euro would strengthen and possibly steal market share to gold within the reserve currency market.

To begin with, in the past 48hrs, this scenario has been gaining weight with the consensus expecting a resolution on this in March. The common sense question, a question we’ve been approached by readers is whether the scenario is already priced in. We think there is still room for this view to crystallize, taking the Euro over the $1.40 level and bank credit spreads materially tighter. The obvious risk here is that the banking sector may not heal if Euro politicians overshoot on their wish to effectively convert banks’ senior bondholders into contributors contingent capital. But…how can they not overshoot? The mere suggestion of this folly is enough to hurt. The other risk is that a stronger Euro and continuous fiscal cost-cutting affect aggregate demand, questioning the sustainability of the status quo (= the avoidance of a restructuring). But we want to leave you with this: Regardless of what takes place, the ECB is by far way more capable of handling this mess than the Fed is, simply because the European Central Bank has not used any ammunition yet. Until now, they have been sterilizing their purchases of sovereign debt. Remember, this is a beauty contest and all they need is to just look a little bit better than the competition.

With regards to the exposition we gave in our last letter, we received questions from readers asking if we assumed that the EFSF would purchase government debt at par or at market prices. We think at neither. By definition, if market prices were “clearing prices” that excess supply of debt would not be sitting on the asset side of the banks’ balance sheets. For consistency, if the ECB currently applies haircuts to the debt, the EFSF will also not pay par. The uncertainty around pricing, as well as quantity and source is what is delaying, in our view, this transaction.

Now, in our last letter too, we concluded that if the Euro strengthened, it would only be natural to see gold weaken. Since yesterday, after the announcement that the ISM’s factory index last month rose to 60.8 (the fastest pace in more than six years), the negative correlation between the Euro and gold broke, as the chart below shows (source: Bloomberg; price of gold in $/oz on white line), and both rallied. This was a very bullish signal and we took due note. Does this mean that the competition between the two candidates for the world’s reserve currency will disappear? We don’t think so. This is just a truce. Problems are being postponed. In the meantime, carpe diem! Enjoy the ride. (Lastly, we have not dealt with the situation in the Middle East, but we will write our thoughts on it later. So far, we faded the rally in oil and instead traded the view that on the margin, capital will leave the energy sector in the Middle East for a safer place in Canada. To date, the market is telling us we were right on this one… )

Martin Sibileau.